Macroeconomic Theory

Introduction to Economics (Econ 101) T. J. Mukura Dept of Economics

University of Zimbabwe

Key Texts
Colander, D. C. (2004), Macroeconomics, 5th Edition, McGraw-Hill/Irwin Gwartney, J. et al (2009), Economics: Private & Public Choice, 12th Edition, Thomson South-Western Lipsey, R. G., Ragan, C. T. S., & Storer, P. A. (2008), Desk Copy for Economics, Microeconomics & Macroecononmics,13th Edition, Pearson Education Inc. Mconnell, C. R. & Brue, S. L. (2002), Macroeconomics, 15th Edition, McGraw-Hill Higher Education

AS AD Model
Aggregate Supply (AS) captures the production and pricing decisions by firms Aggregate Demand (AD) captures aggregate spending decisions The AS-AD Model focuses on aggregate expenditures as the primary determinant of short-run income It consists of three curves:
i. ii.
iii.

Short-run aggregate supply curve (SRAS) Long-run aggregate supply curve (LRAS) describes the highest sustainable level of output Aggregate Demand Curve

i.

Unlike the microeconomic supply/demand model, the AS-AD Model

deals with the general price level of all goods and the aggregate output in the economy as opposed to single good prices and quantities Is a historical model starts at a particular point in time and says what will likely happen when changes affect the economy
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ii.

AD Curve
Shows how a change in the price level will change aggregate expenditures on all goods and services in an economy Indicates the various quantities of domestically produced goods and services that purchasers are willing to buy at different price levels The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods and services demanded and the price level due to:
i. ii. iii. The wealth effect A lower price level increases the purchasing power of the fixed quantity of money leading to increased consumption expenditure The interest rate effect A lower price level will reduce the demand for money and lower the real interest rate leading to an increase in investment expenditures The international effect assuming a constant exchange rate, a lower price level will make domestically produced goods less expensive relative to foreign goods which leads to an increase in exports The multiplier effect the amplification of initial changes in expenditures

iv.

AD Curve Diagram
Price Level

P1 P2

AD
Y1 Y2

Goods & Services

(real GDP)

As illustrated above, when the general price level in the economy declines from P1 to P2, the quantity of goods and services purchased will increase from Y1 to Y2.
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Shifts in AD
A shift in the AD curve means that at every price level, total expenditures have changed Anything other than the price level that changes components of AD (C, I, G, (X-M)) will shift the AD curve There are five main shift factors
i. Foreign income a rise in foreign income means more domestic goods demanded (more exports) hence an increase in AD AD curve shifts to the right ii. Exchange rates a fall in the value of the domestic currency makes domestic goods more competitive leading to increased foreign demand for domestic goods AD shifts to the right iii. Expectations expectations of higher future income leads to lower current savings and increased expenditures AD curve shifts to the right iv. Distribution of income some people save more than others hence as income distribution changes, AD will also change accordingly v. Government policies gvt can manipulate AD through fiscal and monetary policies e. g. an increase in gvt expenditure or tax cut shifts the AD curve to the right Due to the multiplier, the AD curve may shift by more than the amount of the initial shift factor

Aggregate Supply
When considering the Aggregate Supply curve, it is important to distinguish between the short-run and the long-run.
Short-run: A period of time during which some prices, particularly those in resource markets, are set by prior contracts and agreements. Therefore, in the shortrun, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. Long-run: A period of time of sufficient duration that people have the opportunity to modify their behavior in response to price changes
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SRAS Curve
SRAS indicates the various quantities of goods and services that domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market. In other words, it specifies how a shift in the aggregate demand curve affects the price level and real output in the short-run, ceteris paribus The SRAS curve slopes upwards reflecting the fact that, in the short-run, an unanticipated increase in the price level will improve the profitability of firms Firms respond to this increase in the price level with an expansion in output
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SRAS Curve Diagram

Price Level

SRAS

P105

P100
P95

Y1

Y2

Y3

Goods & Services

(real GDP)

In the short-run, firms will expand output as the price level increases because higher prices improve profit margins since many components of costs will be temporarily fixed as the result of prior long-term commitments.
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Shifts in the SRAS Curve

Factors that lead to a shift in the SRAS include: i. Changes in input prices an increase in input prices shifts the SRAS up, opposite is true ii. Changes in expectations about inflation these work through wages (an expected increase in prices leads to demand for wage increments hence an upward shift in the SRAS curve) iii. Excise and sales taxes higher sales taxes shift the SRAS up iv. Import prices when they rise, the SRAS curve shifts upward v. Productivity an increase in productivity reduces inputs per unit output , thus reduced cost per unit, leading to a downward shift of the SRAS
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LRAS Curve
LRAS indicates the relationship between the price level & quantity of output after decision makers have had sufficient time to adjust their prior commitments where possible. LRAS is related to the economy's production possibilities constraint.
A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements. Therefore, an increase in the price level will not lead to a sustainable expansion in output.

Thus, the LRAS curve is vertical.

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LRAS Curve Diagram

Price Level

LRAS

P2

P1

Potential GDP

(full employment rate of output) F

Goods & Services

(real GDP)

In the long-run, a higher price level will not expand an economys rate of output. Once people have time to adjust their long-term commitments, resource markets (and costs) will adjust to the higher levels of prices and thereby remove the incentive of firms to continue to supply a larger output.
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Shifts in the LRAS Curve

The LRAS shifts for the same reasons that potential output shifts, i.e. due to changes in the
i. ii. iii. iv. v. Capital stock Available resources Growth-compatible institutions Technological progress Entrepreneurship

An increase in the above shifts the LRAS to the right and vice versa
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Short-run Equilibrium in the Economy

Short-run equilibrium occurs at the price level where the aggregate quantity demanded is equal to the aggregate quantity supplied. This occurs (graphically) at the output rate where the AD and SRAS curves intersect. At this market clearing price P, the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply during the current period.

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Short-Run Equilibrium Diagram

Price Level

SRAS

AD
Y

Goods & Services

(real GDP)

At prices below P, general excess demand pushes prices upward. Equally, at prices higher than P, excess supply forces prices down.
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Shift in the AD
Price Level

SRAS

P1 P

B A

AD1
Y

Y1

Goods & Services

(real GDP)

A rightward shift of the AD curve changes equilibrium for A to B, increasing output from Y to Y1 and the price level from P to P1
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Shift in the SRAS

Price Level

SRAS1 SRAS

P1 P

D C

AD
Y1 Y

Goods & Services

(real GDP)

An upward shift in the SRAS curve changes equilibrium from C to D, reducing output from Y to Y1 and increasing the price level from P to P1
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Long-run Equilibrium
When long-run equilibrium is present:
Potential GDP is equal to the economys maximum sustainable output consistent with its resource base, current technology, and institutional structure. The Economy is operating at full employment. Actual rate of unemployment equals the natural rate of unemployment.

Long-run equilibrium is graphically determined by the intersection of the AD, SRAS, and LRAS curves as shown in the diagram below

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Long-Run Equilibrium Diagram

Price Level

LRAS

P100

AD100
Y
Y F (full employment rate of output)

Goods & Services

(real GDP)

Long-run equilibrium is determined at the intersection of the Ad curve and the LRAS curve as shown above The subscripts on AD indicate that buyers and sellers alike anticipated the price level P100 (where 100 represents an index of prices during an earlier base year). When the anticipated price level is attained, output YF will equal potential GDP and full employment will be present.
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Shift in AD
Price Level

LRAS

SRAS

P2

P1

AD1 AD2
Y
Y F (full employment rate of output)

Goods & Services

(real GDP)

In the long-run (at potential output YF), the AD curve can only determine the price level; it does not affect real output level. As shown above, when AD increases from AD1 to AD2, the price level increases from P1 to P2 but output remains at YF. Output is not determined by AD but by potential output.
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Short- & Long-Run Framework

Price Level

LRAS

SRAS100

P100

AD100
Y
Y F (full employment rate of output)

Goods & Services

(real GDP)

In the above instance, the economy is in both a long-run and short-run equilibrium since the AD and SRAS intersect at the LRAS curve i.e. all three curves intersect at the same point At this point, aggregate demand is growing at the same rate as potential output Growth and unemployment are at their target rates with no or minimal inflation
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Recessionary Gap
Price Level

LRAS SRASo

P1
PF
Recessionary gap

SRAS1

B AD
Y1 YF
Goods & Services
(real GDP)

The short and long-run equilibriums do not always coincide. The above diagram shows a situation, at point A, where AD is below potential output and resources are not fully employed. The distance (Yf Y1) shows the amount of output not being produced but could be. This is known as the recessionary gap the amount by which equilibrium output is below potential output.
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Recessionary Gap Contd

With time, costs and wages will fall due to the excess supply of factors of production resulting in a fall in the price level The SRAS curve will then shift down from SRAS0 to SRAS1 until the long- and short run equilibrium is reached at B However, usually before prices fall, the government institutes policies that increase AD resulting in the AD curve shifting to the right thus eliminating the recessionary gap while maintaining a constant price level
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Inflationary Gap
Price Level

LRAS SRAS1

PF
P1

D C SRAS0 AD1
Inflationary gap

YF

Y1

Goods & Services

(real GDP)

Point C shows an economy where the short-run equilibrium is at a higher income than the potential output. The distance (Y1 YF), the amount by which aggregate expenditures outstrip potential output that exists at the current price level , is known as the inflationary gap.
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Inflationary Gap Contd

The economy will not stay at C for long as resources are being strained. To increase factors, a firm must lure resources away from other firms resulting in the bidding up of factor prices Factor prices will rise and the SRAS curve will shift up from SRAS0 to SRAS1 and the new equilibrium will be at D However, government may not wait for this but will institute AD policy which will shift the AD curve to the left to contract output and eliminate the inflationary gap
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Summary AS/AD Model

What shape is it? AD Downward sloping: As the price level declines, expenditure rises Upward sloping: The price level increases as output increases. Vertical: Changes in price level have no effect on output. What determines shape? The wealth, interest rate, international an multiplier effects What shifts the curve? Sudden changes in C, I, G, or (X-M) caused by changes in foreign income, expectations about future income or prices, exchange rates, monetary and fiscal policy Increases in input prices shift the SRAS curve up. Decreases in input prices shift the SRAS curve down Anything that increases potential output, such as increases in available resources and technological innovation

SRAS

Firm behaviour. Most firms change production instead of price when demand changes. Some firms will raise prices when output increases Potential output is output that the economy can produce when labour and capital are fully utilized. It is not affected by prices

LRAS

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